September 28, 1982

September 28, 1982 | Backgrounder on Energy and Environment

Energy Policy and the Market

(Archived document, may contain errors)

214 S. Fred Singer Senior Fellow INTRODUCTION For 25 years, the U.S. government has played an increasing role in energy matters, but has pursued an inconsistent policy.

On the one hand, it has t ried to make energy cheap in order to benefit consumers; on the other hand, it has made energy expensive to benefit producers.' For example, natural gas prices have been held at low levels since 1954--for most of the time, on the order of a few cents per m illion BTU.l During the 1960s, however, oil producers were protected from cheaper imports and were able to sell oil at around 3 a barrel, or 50 cents a IVPIBTU Had low-cost Middle East oil been allowed to enter without restriction, the September 28, 1982 I ENERGY POLICY AND THE MARKET These contradictory policies of the U.S. government result in political conflict and compromise between oil-consuming states like Massachusetts) and oil-producing states (like Texas In trying to please both consumers and prod ucers, the U.S. Congress has produced a quagmire of policies and involved the federal government more deeply in--thus distorting-the energy fuel market.

By 1970, price controls had led to serious shortages of natural gas because of excessive consumption by consumers and 1,000 cubic feet (1MCF) of gas has a heat content of 1 MMBTU, one million BTU, or about one gigajoule.

By 1982, prices for gas and oil averaged about $2 and $6 a MMBTU, respec For example, wellhead prices for natural gas may range from $0.5 0 to $9 per MCF, in the same state L t ivel y 2 inadequate incentives for producers fill the demand. In 1971, the Nixon Administration imposed price controls also on crude oil. They remained in effect for ten years, even after world prices rose above the domestic 1evel.h 19

73. As a result, a domestic market developed which basically had two tiers: cheap, price-controlled domestic oil and expensive uncontrolled imported Mind-boggling regulations were required to establish some measure of equity; a large bu reaucracy was employed to track oil transactions and prices. A special program had to be established to equalize the price of crude oil to all refineries, regardless of the origin of the oil. The overall results of these policies were: greatly reduced eco n omic efficiency; overconsumption of oil because of an effective price subsidy; and a resulting pro-import government policy. Oil imports rose from 23 percent of consumption in 1970 to nearly 50 percent by 1978--partly because of price regulation of both o i l and gas Imported oil was needed to After the 1973 Arab embargo, President Nixon sought indepen dence from oil imports. But it was soon recognized that indepen dence would also mean excessive costs to substitute fuels--well above the prices set by OPEC f o r world oil By 1980 however oil prices had risen sufficiently to make many substitutions economic President Carter injected the federal government even more deeply in energy matters he plugged hard for conservation and solar energy in his first National E nergy Plan of 19

77. But because he did not free oil and gas prices, he discouraged conservation and solar energy. By 1979, Carter decided to encourage production. He tried to deregu late (or at least raise) the prices of natural gas and oil and pushed for a large, government-backed $100 billion synthetic fuels program He created a Department of Energy and The Reagan Administration drastically reversed the policies of the previous administrations. One of Reagan's first acts was to decontrol oil prices in J anuary 19

81. He then began dismantl ing the vast machinery designed to enforce regulation proposed abolishing the Department of Energy, which had become a symbol of government intervention in energy markets He even THE FREE MARKET PHILOSOPHY ON ENERGY The Reagan Administration's approach to energy is based on the conviction that a free market can allocate scarce energy supplies most economically and efficiently through prices set by There were additional categories, such as Alaskan oil, "tertiary" oil req uiring costly recovery techniques as well as some uncontrolled new" domestic oil 3 market forces apply these principles consistently, it has encountered obstacles for both historic and political reasons.

A free market is well suited to supply energy. This is because energy resources are owned, e.g by individuals or corporations. The existence of property rights provides incen tives for proper management of resources. Under competitive conditions, management for individual profit also benefits the general p o pulation--a principle originally set forth by Adam Smith. In contrast, certain other natural resources, such as water and air, which are not owned by individuals or corpora tions, are not properly managed by them. It is impossible for anyone to own a parc e l of air--although an owner of a lake or a pond would probably want to take care of it and not discharge wastes into it. There thus is an argument for government concern about air and water quality since no real incentives come from market forces to contr o l pollution Though the Administration has been trying to While the free market approach denies a governmental role in setting fuel prices, there are still important functions which the federal government must perform for energy resources to be used proper l y. In aggregate, these functions comprise a govern ment energy policy. They include 1. Guarantee that a free market exists. The federal govern ment takes action against companies or individuals which inhibit competition. It is also appropriate for governm e nt at the state local and federal levels to regulate certain natural monopolies such as electric power transmission and natural gas pipelines and distributors. The government, along with private groups, can provide information (for example, about energy e f ficiency of cars) to inform consumers so that they can participate more effectively in the market 2. Regulation of interstate transportation of fuels and electric power The interstate commercell responsibility of the federal government also includes preve n ting energy-rich states from taking undue advantage of energy-poor states by exorbitant taxation or other means of price discrimination. This is a matter of current controversy 3. Protection of the environment. As the guardian of national public health an d safety, the federal government, along with the states, sets appropriate quality standards for the ambient atmospheric and water environment. It also licenses energy facilities, such as power plants and nuclear reactors.

Much more can be done to streamline the process of achieving the environmental standards and to speed up nuclear licensing Although a case can be made for deregulation of pipelines, and certainly of electric power generating facilities 4 4. Strategic Petr o leum Reserve. National security is an important federal function. U.S. dependence on imported oil and the possibility that cutoffs could produce severe economic damage led to legislation for a Strategic Petroleum Reserve operated by the federal government 5. Manaqement of public lands. When leasing public lands for oil and gas (especially on the outer continental shelf) and for coal and other energy minerals (including geothermal energy the government acts as a prudent land owner, concerned with maximizing its financial return 6. Advanced research and development. In areas where no single industry or group of industries can capture all the bene fits of its own research and development investments, the govern ment has a role to carry out basic scientific res e arch for future energy sources, such as nuclear fusion 7. International energy cooperation. The federal govern ment has important functions as a party to various international agreements. For example, the International Energy Agency (IEA was set up in 197 4 to operate under the auspices of the Organiza tion for Economic Cooperation and Development. One of its princi pal purposes is to provide for oil sharing in case of major interruptions in world oil supply. Another cooperative venture is the International Atomic Energy Agency, concerned with the exchange of atomic information, and with safeguards against the spread of nuclear weapons 8. Owning and operating enercry facilities. Unlike many other nations, the U.S. does not own refineries or purchase oil on t h e world market provided by private oil companies under government contract Even the fuels used by -the military are The U.S. government is involved in owning and operating certain energy facilities, such as naval petroleum reserves hydroelectric plants in the Far West, as well as the well-known Tennessee Valley Authority which includes hydroelectric, coal and nuclear sources for the production of electricity. (In a sense these federal involvements are now an anachronism.) The Congress has never approved, h owever, creation of a Federal Oil and Gas Corporation (FOGCO although some legislators felt that a feder al yardstick should be used to judge the performance of private oil companies.

It is not easy for the federal government to carry-out these various ene rgy. functions in a consistent manner. The main pro blem is political: how to satisfy the often conflicting desires and requirements of such different interest groups as energy consumers, environmentalists, owners of oil and gas resources different kinds o f energy companies and other more specialized interests 5 CURRENT U.S. ENERGY POLICY: OIL The Reagan Administration energy policy relies on the laissez faire approach of a free market however, are made incrementally. Though the prices of crude oil and oil products have been decontrolled, the Administration has left undisturbed the Itwindfall profits taxtt imposed by Congress in 19

80. This is really an excise tax based on the difference between the world price (i.e the market price) and a base price corres ponding roughly to the production cost plus a Itreasonablett profit. For example, oil discovered before 1978 has a base price of $12.89 and a tax of 70 percent above that. On the other hand post-1978 oil and hard-to-produce IIheavyIl (high-viscosity) oil is taxed at 30 percent on a base of $16.

55. The exact amount of windfall profits tax--likely to exceed $200 billion over the next ten years-and how its proceeds are to be allocated are sure to trigger lively political controversy Administration decisions Past administrations have provided special subsidies to so-called small refiners at the consumer's expense. These bene fits are no longer available. The changing and shrinking market for oil likely to benefit those refiners willing to make cap i tal investments to produce more gasoline and other motor fuels, and less heavy fuel oil. These investments are being made in response to market forces--without any government assistance or direction In the leasing of public lands, the Reagan White House h a s moved more rapidly than any past administration. As a result the energy industry should be able to make its plans with more certainty-and, therefore, more efficiently. This ultimately benefits consumers. It is ironic that the windfall profits tax has re m oved the ready cash of oil companies and so decreased the amount of money which they can pay to the Treasury for oil and gas leases. Some would argue that the best way to tax away a windfall profit is simply to offer more public lands for lease and encour age more oil companies to enter into the bidding An important energy policy issue is emergency allocation of oil products in case of a which usually results from a supply interruption. In a free market this problem disappears.

With prices decontrolled, the re may be a dislocation but not a long-term shortage. The price will simply rise and dampen the demand to match the available supply of oil. The allocation will also be done automatically, with oil flowing to users who can afford to pay a little more of a l locating during a scarcity and requires no government ac tion. The allocations are effected by price and not by political influence. Allocation of the available supply by the free market is also fairly equitable. Even though the poor are pinched by the hi g her price, they also suffer under other systems of alloca tion, such as rationing by coupons (whether per car or per driv er, and whether ration coupons are kept or resold or a politi cal method of distribution without a change in price. The fair This is the most efficient method 6 est method is to let the price rise and recycle increased tax revenues to provide .general aid to the poor-.-without regard to their energy purchases.

The legislatively mandated Strategic Petroleum Reserve (SPR) thus may not rea lly be needed. With decontrolled prices, the allocation of any shortfall could proceed automatically. With an SPR, however, the government, as its owner, has to develop poli cies for releasing the oil: when, how much, and in what manner.

This creates uncertainties which discourage oil companies and individual users from maintaining adequate private stockpiles.

At present, the SPR exceeds 250 million barrels. Some hard decisions will have to be made before the SPR reaches its announced goal of 750 million barrels, a target which has an annual carrying cost of some $5 billion dollars to focus on who should bear this cost and in what manner.

National debate can be expected The Reagan Administration has not yet removed the ban on oil exports from Alaska; this restriction was established by Congress in 1973 in the mistaken belief that it would protect U.S. oil security. But with oil prices decontrolled, oil can be bought freely-even though the price of all oil (including Alaskan would rise in the event of a su p ply shortfall in the world for whatever reason. Currently, Alaskan oil is creating a glut in California, discouraging production at the margin both in Califor nia and Alaska. To avoid a sharp price discount, excess Alaskan oil is shipped through the Panam a Canal to the U.S. East Coast at great expense. Permitting export of Alaskan oil, say to Japan would save nearly a billion dollars per year and would encourage greater development of oil and gas resources in the Arctic Import fees on crude oil or higher f e deral taxes on transpor tation fuels are being widely discussed. They are viewed as means of enhancing conservation, decreasing oil imports (with attendant benefits to national security and trade balance) and increasing Treasury revenues particularly appe a ling if and when world oil prices should de cline drastically--at least for short times could raise havoc'with U.S. domestic energy industry and produce disincentives to energy investments as well as to energy conserva- tion Such fees and taxes might beco m e Such price breaks NATURAL GAS POLICY Natural gas poses a difficult problem--some would say, an insoluble problem deregulate the price and those who would simply maintain ceil ings. Proponents of ceilings include some consumer advocates (who may only be t aking a shortsighted view) and gas pipeline owners who would like to see the price low and demand high to maximize the shipments of gas). Support for ceilings also comes from importers of costly LNG (liquefied natural gas) and producers of expensive Ildee p II gas who look upon the availability of a large reservoir of price-controlled cheaper gas as an opportunity for The major conflict is between those who would 7 Ilrolling in" (price averaging) their higher-priced gas. I1Oldlf gas under contract still sell s for less than 50 cents at the wellhead in many cases, while gas from the same region, but from a deeper structure, can sell for as much as $9 per 1000 cubic feet.

Under,the Natural Gas Policy Act of 1978, about half of all gas, and any IInewIl gas, will be decontrolled in price by 1985.

The consequences of this are difficult to predict. For example intrastate gas (gas produced and sold within the same state would not be subject to control after 1985; therefore gas sup pliers would prefer to sell to the i ntrastate market, producing a shortage in the interstate market--just as was the case before 1978.

Another example: The ultimate effects of the existing "fuel pass-through clause1 by which electric utilities can pass on any increases in the price of their fuels) may be to make the elec tric utilities insensitive to higher gas prices. But if utili ties were to stop using higher-priced gas and switch to coal, a large surplus of gas would develop and U.S. gas prices could remain below the equivalent level of oil for many years. Residen tial and commercial users would then switch to gas more rapidly.

The consequences of this sequence of,substitutions would be a furthering weakening of demand for oil as a heating and boiler fuel, and a reduction in oil imports.

President Reagan's strategy on natural gas deregulation has not yet been announced. Some members of the Administration would like to deregulate the wellhead prices of natural gas immediately and completely. Others favor deregulation for all natural gas bo th old and new, but would like to introduce it gradually to avoid what they fear would be disruptions by 19

85. One controver sial issue undoubtedly will be the imposition of a windfall profits tax on natural gas, similar to the one imposed on oil.

Another may be how to handle existing contracts which set unrealis tic prices for old or new gas.

COAL POLICY Of coal, it used to be said, that it is a great fuel, except that I'you cannot mine it and you cannot burn it The Reagan Administration is likely to mo ve further and faster on coal than previous administrations. For one thing, it will speed up mineral leasing on federal lands. For another, by simplifying strip-mining regulations and by making the Clean Air Act regulations more flexible, Administration a c tions should make coal much easier to mine and burn.6 At the same time, land and air resources should not be'adversely affected 6 The changes being discussed include Modifying regulations about land restoration (following strip-mining to allow regional fl e xibility; to permit creation of level land rather a Some political battles will have to be fought to achieve these changes that environmental regulations can be made more flexible without damaging the land or lowering air quality use. Efforts are underway to lower such costs through the use of Congress and the public will have to be convinced Transportation costs are an important determinant of' coal slurry pipelines, though the railroads oppose this.

Advances in technology undoubtedly will speed the adopt ion of coal as a boiler fuel lfFluidized-bedll combustion provides a low-pollution method for the use of coal, without high-cost llscubberslf for flue gas desulfurization. The development of simple, low-cost coal-water mixtures will make it possible to re place higher-cost fuel oil in existing oil-fired boilers with out major capital expenditures.

NUCLEAR ENERGY POLICY Regardless of U.S. nuclear policy, other countries are now fully aware of the advantages of nuclear energy. It is cheaper than coal and much cheaper than oil. Nuclear energy, on the whole, is environmentally benign, provided that strict safety precautions are enforced. The Reagan Administration has changed and reversed drastically the Carter Administration's policies.

Reprocessing of used fue l elements and disposal of nuclear wastes are being allowed--finally--to commence. The export of nuclear technology not only will be permitted but also encouraged. In addition, work on nuclear breeder reactors may resume, to stretch the uranium resources of the United States and other countries.

The most significant action that U.S. government can take to revive its lagging nuclear program is to streamline the licensing process. Just two steps are necessary: (1) selecting sites for nuclear and other power plants well in advance of need to build up an inventory of approved sites; and (2) standardizing nuclear plants so that the licensing process can be accelerated. These steps not only will cut the time betwen planning and the date of operation (and thereby lower the cost greatly but also make nuclear energy safer than recreating the hilly contours where it is economically more useful and to replace design standards by performance standards, thus improving cost-effectiveness Permitting the burning of low-sul f ur coal without the use of expensive flue gas-scrubbing equipment Setting appropriate standards for ambient air quality, but leaving the implementation methods to the users to be achieved at lowest cost. 9 c OTHER ENERGY RESOURCES AND CONSERVATION With re spect to other energy sources, the Reagan Administra tion has used a laissez-faire approach. Solar energy and synthe tic fuels from coal have been left largely to the market, although there exist important tax benefits which provide a kind of subsidy.

Two shale oil projects and one synthetic gas project have received federal loan guarantees. The Synthetic Fuels Corpora tion, set up under Carter, has become less active. It is clear that th'e government is not going to subsidize the crash program for synthet i c fuels which often has been envisioned by high-level policy planners in the past. On the other hand, Reagan is continu ing government support for research on fusion energy--a long-term program whose impact will not be felt until after the year 2000 The R e agan Administration believes that conservation, whether by fuel' switching or by using energy more efficiently, is best promoted by market forces. Higher prices are supposed to achieve the appropriate level of conservation. The oft-stated idea of encourag ing conservation by legislation--for example, by means of a gasoline tax--has not found much favor in Congress, although an economic case can be made for such a tax based on the negative externalities? produced by driving.

INTERNATIONAL OIL POLICY On the i nternational scene, the.Reagan Administration has made some important new departures. As customary, the federal government is staying out of the purchasing of oil and gas, and letting private companies negotiate detailed arrangements' with foreign supplie rs, both governmental and.nongovernmenta

1. An exception to this general policy has been a direct purchase agreement with Mexico for the Strategic Petroleum Reserve.

The new Administration is likely to deemphasize the role of the International Energy Agen cy (originally conceived as a counter weight to OPEC). Special sharing arrangements of oil supplies during emergencies will undoubtedly be reviewed. Since these sharing arrangements have never been tested, no one knows whether they will really work. With prices deregulated, there may be no need for them at all. In case of supply shortfall, oil will simply flow to individuals willing to pay a premium.

Many "expertstf have worried that an oil Itshortaget1 could break up the Western alliance, as countries com pete for oil in a Harmful and uncompensated side effects, such as accidents, noise, pollu tion, the congestion of roads in cities, and the need to build and main tain roads. 10 beggar thy neighbor" manner. Their concerns are unfounded.

Wealthy Europeans can always outbid those Americans who cannot afford the higher price pay the higher price will get the oil provide subsidized oil for its citizens; the policies of other nations have not yet been defined Individuals--not countries--willi n g to The U.S. is not likely to A major hope of the West has been to discover oil outside the Middle East, in order to diversify sources and make the supply more secure that oil exploration be subsidized, or even completely financed by U.N. agencies or by t he World Bank From time to time, it has been suggested The Reagan Administration prefers exploration by private Since many Third World nations companies--without subsidies oppose multi-national companies, particularly those headquartered in the United Sta t es, these nations may well prefer other financ ing arrangements. One possibility may be an organization for oil development in the Third World which accepts money from OPEC nations-particularly Arab nations with surplus funds. It is likely that much new o i l will be found in the next few years with or without U.S. government involvement. As far as the Reagan Administration is concerned, it will be without U.S. government involvement INTERNATIONAL NUCLEAR ENERGY With the sharp turnabout in the U.S. governmen t 's view on nuclear energy, there will be a freer export of U.S. nuclear technology and of enriched fuel tion that countries wishing to build nuclear weapons are not going to be stopped by the U.S. government. Those countries can build or acquire weapons d i rectly, without first developing nuclear power for electricity production. A number of technically advanced nations are now able to act as suppliers of nuclear technology and fuels, so that the actions of the United States no longer determine what happens to nuclear power in the world community This is based on the realiza Consumers of oil everywhere will benefit from the construc tion of more nuclear plants anywhere in the world. With world demand for oil thereby reduced, downward pressure will be created on world oil prices.

CONCLUSION The Reagan Administration is committed to maximum reliance on the forces of a free market and a minimum of government inter vention. The price of oil is now so high that oil can be re placed by less expensive gas, coal and nuclear energy. These cheaper fuels can be substituted in many applications--principally for producing heat and steam--which make up about 60 percent of 11 world oil use. Government policies need not do much more than remove political and institutional ob stacles to the use of these alternative energy sources. Economics will do the rest S. Fred Singer is on leave from University of Virginia where he is Professor of Environmental Sciences.

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